Author: Matthew Pierce
Covestor models: Income Portfolio, Growth Portfolio, Balanced Portfolio
It’s the beginning of September, and time to go back to school. Expect September and October market volatility to be higher than the last four months, as portfolio managers, brokers and analysts return from vacations. Active managers, behind in their performance, will increase trading and portfolio risk in order to salvage year-end bonuses. Brokers behind in their commission compensation will begin calling for orders again. Volume and volatility should increase.
One of the best things about investing in index ETFs is that there is no need for the manager to increase portfolio risk in order to achieve higher investment return. The monetary incentive to take this kind of risk isn’t present. The very best of the index ETF managers, such as Vanguard, iShares and SPDRs, realize this and do their best to reduce tracking error, the difference between the ETF return and the index return. Those of us who invest in index ETFs benefit.
That’s not to say that our portfolios are free from volatility. As investors, we are in the market and therefore subject to its movement. What we can do is to try to mitigate the effect of downward volatility and the risk of portfolio loss. We try to achieve this through diversification, investing globally and investing in assets that exhibit low volatilities and low correlation with each other.
The cost of this approach is that gains tend not be as high in the short run, when markets are moving higher. The benefit of this approach is to limit losses when equity markets move lower. For example, in 2008, when the US equity market was down approximately 37%, the long term US Treasury bond index was up about 24%. A portfolio invested in equal parts equity and long treasuries would have lost 6%, limiting loss to an acceptable range.
High portfolio volatility penalizes the long term investor. In part, this is due to simple mathematics – a 50% loss followed by a 50% gain leaves a $1 dollar investor with 75 cents in hand. Volatility also affects investor behavior. When confronted with a 50% loss, many investors panic and sell, just when they should be buying. Even the most disciplined investor, faced with the loss of such magnitude, will exhibit undisciplined, but perfectly rational, trading behavior.
Over the last two months, we have investigated alternative ETF investments that may help us to control risk through effective diversification. We classify alternative investments into alternative asset classes and alternative asset strategies. We have invested in alternative asset classes for a long time, and ETFs are a particularly effective means of achieving exposure to these non-traditional markets, such as gold, emerging market bonds, and low volatility equities.
This month, we introduced alternative asset strategies into our portfolios. Some of the alternative strategy ETFs we’ve considered include securities that seek to replicate hedge fund returns, manage commodities and equity index futures, and mimic arbitrage, momentum and relative value strategies. Alternative investment strategies can be classified as fixed income complements, equity complements and portfolio diversifiers. The two new ETFs that we selected act as an equity complement and as a diversifier respectively, and made it into the portfolios in our September 4 rebalance: iShares Alternative Trust ETF (ALT) and PowerShares S&P 500 Low Volatility ETF (SPLV). Each of these new funds should help to reduce portfolio volatility.
In addition to the introduction of these new ETFs, we traded into the Russell 200 Large Cap ETFs from iShares and out of Russell 1000 Large Cap ETFs. This is to minimize overlap in security holdings between the Russell 1000 and Russell MidCap indexes.
In addition to these changes, we retain our desired exposures in the current portfolios, which continue to be relative underweight in Europe and international markets overall, and a relative overweight in value stocks, smaller capitalization equities, long term treasuries and high yield bonds. We retain a large exposure to gold as a diversifying asset.
The Island Light Income Portfolio gained 1.4% in August and is up 7.2% for the year, with a beta of 0.43 relative to the S&P 500 and a current yield of 2.5%. Its direct benchmark, the Dow Jones Conservative, is up 5% for the year, while the S&P 500 is up 11.8%. (All data as of 8/30)
The Island Light Balanced Portfolio gained 1.8% in August and is up 3% since its 1/27/12 inception, with a beta of 0.74 relative to the S&P 500 and a current yield of 2.5%. Its direct benchmark, the Dow Jones Moderate, is up 3.3% since the model’s inception, while the S&P 500 is up 6.7% since the model’s inception. (All data as of 8/30)
The Island Light Growth Portfolio gained 1.8% in August and is up 3.6% since its 1/18/12 inception, with a beta of 0.96 relative to the S&P 500 and a current yield of 2.4%. Its direct index, the Dow Jones Moderately Aggressive, is up 5.2% since its inception, while the S&P 500 has gained 7.5% in that period. (All data as of 8/30)
As of 9/1, the Income Portfolio index is 40% global equities, 60% U.S. fixed income. The Balanced Portfolio index is 60% global equities and 40% U.S. fixed income. The Growth Portfolio is 75% global equities and 25% U.S. fixed income.
Island Light’s investment process is designed on a process called Enlightened Investing. Enlightened Investing is a stable approach to portfolio management, emphasizing quantitative principles and proven investment practices, while accentuating asset allocation as the most important determinant of long term success in investment planning. This approach is designed for the long term investor.
